Tesla Motors (TSLA) has been one of the hottest stocks on the market. Shares of the company have appreciated roughly 575% in the past one year and the demand for Tesla's Model S has exceeded production. But are the company’s prospects blown out of proportion?

Aswath Damodaran, a professor of finance at New York University, may not be a household name, but he's made some of the most accurate share valuations in the recent past, predicting Apple's peak and Facebook's low, to name a couple. And now, after doing his math on Tesla, Damodaran concluded that Tesla is worth $67.12. When he came up with this figure, Tesla was trading at $170.62, and after working out a comparative index, I believe he may be right.

Tesla is charging close to $950,952 per car, which translates into around 14 times the actual cost of the vehicle under the assumption that it is free to manufacture! Given real operating gross margins of 13% on its $70,000-priced Model S, Tesla is generating about $9,000 in gross profit from each car that it manufactures. Despite that, investors are placing an irrational valuation of around $950,952 on every car! Going by such calculations, Tesla will need to enhance its production by 20 times in order to be twice as expensive as Honda, which is the next big car maker, on a value-per-car basis.

A 20-fold jump may seem far-fetched, but that is exactly what Tesla bulls anticipate, and they expect it to happen before 2020. But even if the company somehow manages to multiply its production by a factor of 20, will it justify a market cap of $20 billion or will it have to sustain its growth for a longer period of time to justify today's share price? Let's take a look.

Luxury Models

Obviously, there's no assurance that Tesla will meet the towering goals set by investors. As the company continues to ramp up the production of vehicles, there are a few roadblocks which may harm its progress. One major concern for Tesla is inadequate supply of batteries. Nevertheless, let's give Tesla the benefit of the doubt and assume that the company does manage to overcome all technical hindrances so that demand becomes the only parameter.

The company believes that there is adequate demand in the market for it to boost the production of the Model S to 40,000 units annually within a span of one year. The addition of a new crossover — Model X — in 2014 will augment the total demand, but on the flip side, the launch of the Model X might also reduce the demand of Model S to some extent. Whatever the case may be, it looks like Tesla will struggle to sell more than 100,000 luxury cars yearly anytime soon.

Economical Models

The real key to Tesla's success lies in the company's ability to innovate a lower-priced model without deteriorating its quality. Over the previous conference call, Elon Musk stated that he saw a "clear path" for starting the production of a $35,000 vehicle with a range of 200 miles, which could go into production by as soon as 2016.

Such an economical vehicle will have a lesser margin than the lavish Model X or Model S. Even though Musk is of the opinion that Tesla could probably provide competition to Porsche with gross margins of around 50%, it would only be likely if Tesla is able to maintain its Porsche-like average selling price of around $100,000.

A $35,000 car would have a lower gross margin of say 15%. But Tesla cannot afford to cut down quality, hence it must begin at a quality level consistent with other cars in the $100,000-price range, such as BMW's 3-Series, Daimler's Mercedes C-Class, or General Motors' Cadillac ATS. The cost of batteries and an electric Powertrain (when stacked up against a standard internal combustion engine) are added costs for Tesla. Also, if Tesla grows as per expectations, its vehicles will not be eligible for the $7,500 federal tax credit in the U.S., since the credit begins to phase out after a car maker manufactures 200,000 plug-in or all-electric vehicles.

What Next?

Assuming Tesla can sell 400,000 "reasonably priced" cars in 2018 for $35,000 a piece at a 15% gross margin, it would earn just over $2 billion in gross profit. In comparison, Tesla's operating expenses currently clock an annual run rate of $450 million. However, with Tesla expanding its portfolio from one vehicle today to three to four different models in 2018, and growing sales by more than 20 times, operating expenses could easily jump to $2 billion, or higher, by then.

Simply said, while a cheaper car will help Tesla hit the mass market and sell higher volumes, most of the additional revenue will be negatively compensated by an accompanying increase in operating expenses. To generate billions of dollars in free cash flow — which is what investors expect from Tesla going by its valuation — Tesla will need to generate Porsche-like gross margins.

Hence, Damodaran's view that Tesla is highly overvalued certainly holds weight. Also, institutional investors have been reducing their stake in the company. Tesla has some real challenges ahead of it and that's why investors should stay away from it until and unless there is more clarity as to how it plans to generate positive cash flow and scale up its business to achieve a highly inflated valuation.

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